Lost in the Maze

It has been almost six years since companies began complying with FAS 133, the standard that governs the accounting treatment of derivatives. Yet judging from the growing number of restatements due to FAS 133 errors, many are still wrestling with these rules. Last year, 57 companies restated their earnings because of faulty hedge accounting, up from 27 in 2004 and 13 in 2003, according to Glass Lewis — Co. of San Francisco, which specializes in assessing corporate risk. The biggest such restatement, Fannie Mae's, was still pending at press time. First announced in December 2004, it is expected to lower the earnings from previous years by a whopping $10.8 billion.

The spike in restatements can be partly attributed to Sarbanes-Oxley. (Indeed, restatements overall have risen sharply since 2003, from 514 to about 1,200 in 2005.) But the companies producing the restatements frequently cite two other reasons for the problems: overly rigid requirements, and the complexity of the rules.

"While we took great care in implementing FAS 133 in 2001, including a review by our independent auditors, it is a very complex accounting standard," said Lee Puschaver, executive vice president and CFO of the Federal Home Loan Bank of Atlanta, in a statement last August. (Puschaver resigned this past February.) The bank is one of several in the federal home-loan bank system that have been obliged to restate prior years' financials, and abandon hedge accounting for the positions in question, as a result of inadequate compliance with the rule.

Onerous and Unforgiving
In a 2004 study, Fitch Ratings found enormous inconsistencies in corporate implementations of FAS 133, which created considerable confusion for investors and rating agencies. Last November, Fitch announced that the situation had not improved, judging from the jump in restatements alone (see "Disclosing Derivatives" at the end of this article).

Indeed, the situation is likely to get worse as the use of derivatives increases. In the last 12-month period for which data is available — the end of the first half of 2004 to the end of the first half of 2005 — total notional amounts of interest-rate and currency derivatives outstanding rose 22 percent, from $164 trillion to $201 trillion, according to the International Swaps and Derivatives Association. More than 90 percent of the world's largest companies use derivatives to hedge risk, reports the ISDA.

Under FAS 133, these companies are required to mark derivatives to market and record them as assets or liabilities in their financial statements. To mitigate the increased volatility the mark-to-market requirement can produce, companies may qualify for hedge accounting if used to offset the risk associated with a particular asset or liability. With hedge accounting, losses or gains in a derivative's value do not have to be recorded in earnings until it is offset by gains or losses in the hedged items.

To qualify for hedge accounting, a company must document all derivative hedges at their inception and explain how it will determine the effectiveness of the hedges. It must also demonstrate that the derivatives are "highly effective" in hedging the underlying item on a continuing basis. If the company fails to do this, it will be disqualified from using hedge accounting and will be required to record losses or gains on its derivatives in current earnings.

From the moment FAS 133 was proposed in June 1998, it has been widely criticized. After substantial modification, the rule was finally adopted in 2001, but the complaints have not abated. Added to the concerns about onerous if not impossible requirements, companies today are upset by the enormous amount of resources devoted to trying to satisfy them. On top of that, they say, auditors are conducting unforgiving reviews.

Moreover, the fix for a lapse in documentation is draconian. A company may not simply correct the effort; instead, it must forgo hedge accounting for the position and restate to mark the derivative to market in current and prior earnings.

Shortcut Shortfalls
The devil lies in the details.

Take the so-called shortcut method, which exempts companies from the requirement that they prove the effectiveness of a hedge prospectively and on a continuing basis — as long as they meet a set of nine criteria specified in FAS 133. Mark Scoles, a partner in Grant Thornton's accounting principles group, says that using the shortcut method without meeting all the criteria is a common problem among restating companies.

In particular, companies frequently stumble over the requirement that the fair value of a swap at its inception be zero. They can belatedly realize that because a broker fee was embedded within the swap, its fair value was therefore not zero.

That was the case with General Electric Co., which announced a hedge accounting restatement in May 2005. Before the rule was enacted, GE had entered into swaps with up-front fees, says Philip D. Ameen, the company's comptroller. When FAS 133 was adopted, GE reasoned that the fees on those swaps were trivial, and applied the shortcut method to those hedges. But in a subsequent audit review, GE concluded that because the swaps' fair values at inception were not zero, using the shortcut method was improper.

Another shortcut-method criterion many companies have overlooked or misinterpreted is the prohibition against hedging debt with an interest-rate swap if the debt could have been prepaid.

Vienna, Virginia-based Allied Defense Group Inc. has had to restate its earnings at least twice in the past year because it failed to provide "contemporaneous" documentation of its hedges, says CFO Robert Dowski. This common pitfall can arise from a misunderstanding about the definition of "contemporaneous," according to a partner at one of the Big Four. According to FAS 133, the documentation must occur "at the inception of the hedge," says the partner, who spoke on condition of anonymity. But accountants can disagree as to whether that means the same day, the same week, or the same month, he adds.

Flawed Practice?
Complexity, ambiguity, and overly strict requirements may not be the only reasons for the hedge accounting restatements. Some attribute the problem in part to widely shared but incorrect accounting practice. Observes Glass Lewis analyst Jason Williams in a January report on hedge-accounting restatements: "It appears companies actually failed on some of the simpler aspects of [FAS 133]."

"It's a matter of companies following accounting guidance based on the industry norm," says Mark Grothe, an analyst at Glass Lewis. He compares the spate of FAS 133 restatements to those stemming from lease accounting in 2005.

Williams offers sharper words in his January report. "Some companies and their finance executives appear to be incapable of following published accounting rules," he writes. Citing as examples the "big bath" restructuring charges and acquisition-related write-offs that were common in the 1990s, Williams then moves on to lease accounting: "In 2004 and 2005, close to 300 companies that failed to follow black-and-white lease accounting rules that were 30 years old had to correct the related errors in their financial statements."

And today? "In the latest rendition of this hocus-pocus type of accounting," he says, "we are seeing 'hedge' accounting disappear before investors' very eyes." While Williams allows that some aspects of FAS 133 are indeed complex, "the proper application of the shortcut criteria should not be that difficult for accountants with appropriate expertise."

Fixing the Problem
Hocus-pocus or not, companies' struggles with FAS 133 are not going to vanish overnight. Financial executives have varying opinions about how to stem the rash of restatements. Allied's Dowski would like to see auditors and regulators be more reasonable in their review of hedge accounting. "I think hedge accounting is the accurate way to portray this use of derivatives," he says. "But it doesn't need to be an all-or-nothing test. It should be good enough if documentation and the rest were done on a 90 percent–correct basis."

Ameen agrees. General Electric already has the equivalent of 40 people working full-time to ensure the accuracy of its hedge accounting and will continue to strive for perfection, he says. But mistakes are inevitable, he adds, particularly at companies like GE, which hedges currency, commodity, and interest-rate risk with derivatives and has thousands of derivatives contracts outstanding at the end of any given year (about 6,000 at the end of 2005). An accounting standard that requires perfect execution will lead to reporting that misses the economics, says Ameen.

And if regulators continue to insist on perfection? In that case, some companies will consider abandoning hedge accounting. Allied, for example, may go this route if it doesn't achieve perfection by the end of the first quarter, Dowski says. Then, his company will deal with the "phantom gains and losses rolling through the P&L" that can result from derivatives accounting by "footnoting the heck out of it," he says.

Others contend that the problem is often a lack of understanding of derivatives and hedging. Hedging is complex, and FAS 133 simply reflects that reality, says Ed Ketz, an associate professor of accounting at Smeal College of Business at Pennsylvania State University. Any company that is unable to do the accounting simply does not sufficiently understand hedging and probably should not be using it. "The documentation is not excessive," says Ketz. "It's what I'd expect a company to do if I were investing."

In its 2004 study of how companies implemented FAS 133, Fitch Ratings recommended the addition of numerous new disclosure requirements that would assist analysts in understanding and assessing companies' hedging activities. In particular, Fitch said that more disclosure was necessary so that investors and analysts could appropriately adjust the effects of hedge accounting on credit ratios. At times, analysts and investors could choose to ignore the effects of hedge accounting, as volatility that can create confusion about a company's true financial condition is shifted from the earnings statement to the balance sheet. Among the disclosures Fitch recommended was a roll-forward of the fair-value balance-sheet values of derivative positions.

Largely in response to Fitch's critique, the Financial Accounting Standards Board formed a "Derivatives Disclosure Project" last fall to consider and ultimately recommend changes in the required disclosures under FAS 133. Those recommendations, to be developed by representatives of accounting firms, companies, and financial institutions, as well as by academics and analysts, should be ready for public consideration by the end of June, says Stanley Stuart Moss, manager of the project.

Comments Raja Akram, senior director in credit policy at Fitch: "While there seems to be no light at the end of the tunnel in terms of making accounting for these instruments less complex than brain surgery, maybe help is on the way through better disclosures that can help investors understand the risk better." But even if there are changes in disclosure requirements, they are unlikely to have any impact on restatements. For companies to get the accounting right, either the rules will have to change or companies will have to learn how to comply with the rules. — L.C.

Take It BackHedge Accounting Restatements in 2005*

Company

Reasonsfor Restating

Effect on Earnings

Abington CommunityBancorp

Requirements for hedge accountingnot met

Decrease by $0.4M

Allied DefenseGroup

Improper documentation

Decrease by $23M

American InternationalGroup

Improper documentation

Increase of $500M

Ameritrade

Improper documentation

Decrease by $10M

Bay View Capital

Derivative instrument not accounted for as derivative

Increase of $0.4M

Cardinal Financial

Incorrect valuation

Not disclosed

Celgene

Derivative instrument not accounted for as derivative

Increase of $22M

Center Financial

Improper application of shortcut method

Increase of $0.2M

Ceridian

Requirements for hedge accounting not met

Increase of $38M

CIT Group

Improper application of shortcut method

Increase of $37.5M

CT Communications

Requirements for hedge accounting not met

Decrease by $0.1M

ECC Capital

Incorrect valuation

Increase of$6M to $8M

General Electric

Improper application of shortcut method

Increase of $538M

Glenborough Realty Trust

Improper documentation and recording of derivative fair value

Increase of $4K

Hersha Hospitality

Instrument not timely designated as hedge

Decrease by $0.1M

Impac Mortgage Holdings

Improper documentation

Decrease by $85M

Interpool

Improper documentation

Increase of $0.1M

Kilroy Realty

Requirements for hedge accounting not met

Increase of $4.2M

Liberty Media

Embedded derivative not separately accounted for

Increase of $14M

MBIA

Improper application of shortcut method

Increase of $6.8M

MortgageIT Holdings

Improper documentation

Decrease by $0.1M

New York Mortgage Trust

Not disclosed

Increase of $0.1M

Northeast Utilities

Requirements for hedge accounting not met

Decrease by $46M

OM Group

Improper documentation

Increase of $0.1M

Petroleum Development

Requirements for hedge accounting not met

Decrease by $2M

Provident Bankshares

Improper application of shortcut method

Decrease by $0.7M

Pulaski Financial

Improper application of shortcut method

Decrease by $0.5M

Banking Corp. of Florida

Requirements for hedge accounting not met

Decrease by $0.2M

South Financial Group

Improper application of shortcut method

Decrease by $15M

SWS Group

Incorrect valuation

Increase of $3M

Taylor Capital Group

Improper application of shortcut method

Decrease by $1M

US Airways/America West Airlines

Requirements for hedge accounting not met

No impact

United Mobile Home

Improper documentation

Decrease by $0.3M

Western Gas Resources

Instruments do not meet definition for derivative classification

Decrease by $20M

* Companies listed are with market cap greater than $100 million. A total of 57 U.S. companies restated in 2005 due to hedge accounting.